Moody's Investors Service on Friday threatened to cut Italy's credit ratings in the next 90 days on worries that a possible rise in euro-zone interest rates may derail the country's fragile economic recovery.

The move underlines the risks facing debt-burdened European nations as they struggle to bring their budgets under control and avoid the kind of crisis that has sent Greece's economy into a tailspin and forced a reshuffling of its government.

Moody's placed Italy's Aa2 rating on review for downgrade, saying structural weaknesses such as a rigid labor market pose a challenge to growth. It also highlighted concerns about funding conditions of countries with high debt levels.

Italy has had structural impediments to growth for some time. However, today, these challenges coexist with a scenario of rising interest rates and fragile market sentiment, Moody's analyst Alexander Kockerbeck told Reuters in an interview.

The European Central Bank at its last policy meeting earlier this month held interest rates steady at 1.25 percent but signaled that it will raise rates in July.

The Moody's review comes amid rising concerns that Italy will face difficulties in implementing fiscal consolidation plans required to reduce the nation's debt and keep it at affordable levels.

Kockerbeck said Italy's rating will also depend on the resolution of the overall European debt crisis and its impact on euro-zone interest rates.

Moody's announcement came after European markets had closed for the weekend. In late New York trade, the euro trimmed gains against the U.S. dollar, falling to $1.42770 from about $1.43180 before the news. It was last at $1.42830, still up 0.5 percent on the day.

Italy's potential downgrade highlights the tough conditions for some European nations, with Greece having the most acute fiscal problems as it struggles to adopt more austerity measures.

The Moody's news on Italy reinforces the ECB's concern about the prospect of contagion. And contagion should not happen, said Greg Salvaggio, senior vice president at Tempus Consulting in Washington.

As a result, I think there's a going to be a package put together over the weekend, which is going to effectively offer Greece another lifeline. No one, however, is going to deal with the issue and (they will) simply kick the can down the road.

In its report, Moody's said Italy's economy has long-term structural weaknesses such as low productivity as well as labor and product market rigidities that have impeded growth over the last 10 years.

Italy has so far only recovered a fraction of the nearly seven percentage points in GDP that it lost during the global crisis, despite low interest rates, which are likely to rise in the medium term, Moody's said.

Italy's 10-year government bond spreads narrowed on Friday by 9 basis points to 186 basis points over benchmark German bunds.

Earlier on Friday, Greek bonds rallied as a tentative agreement by France and Germany on broad steps over how to move forward with a second Greek aid package prompted investors to cash in on recent gains in German bonds.

Greece's 10-year bond yields dropped 95 basis points to 17.53 percent.

Standard & Poor's rating on Italy's long-term sovereign foreign currency credit rating is two notches below Moody's, at A-plus with a negative outlook. Fitch's ratings is between S&P and Moody's, with an AA-minus rating and stable outlook.

Unfortunately, the news flows of European downgrades will only increase the volatility (in) the markets, said David Kelly, chief market strategist at J.P. Morgan Funds in New York.

Greece is in the most financial trouble in Europe ... Other countries including Italy clearly have budget issues. This shows that Europe can't wash its hands of the Greece situation. It must isolate the problem with Greece and help other countries to deal with their fiscal issues, he added.

(Additional reporting by Burton Frierson, Pam Niimi, Richard Leong and Gertrude Chavez-Dreyfuss; Editing by Leslie Adler)

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